November 14, 2013
Pite Duncan, LLP
USFN Member (California)
With the increase in real property values in recent months, undersecured creditors should consider the benefits of Bankruptcy Code § 1111(b) as an effective tool in defending against a “cramdown” of a claim in a Chapter 11 plan of reorganization. In general, an 1111(b) election prohibits a debtor from bifurcating a claim into secured and unsecured portions under § 506(a) and permits a creditor to retain its fully secured claim, including post-petition attorneys’ fees, escrow advances, and other costs recoverable under the applicable loan agreement, less any post-petition interest. In re SNTL Corp., 571 F.3d 826 (9th Cir. 2009).
When to Make an 1111(b) Election
A creditor must make its election prior to the conclusion of the hearing on the disclosure statement or within such later time as the court may fix. Fed. R. Bankr. P. 3014. A secured creditor should consider making an 1111(b) election when the collateral securing its claim has substantially depreciated in value (50 percent is a suitable benchmark) and a debtor’s Chapter 11 plan proposes to cramdown the claim to the value of the property. An 1111(b) election protects a creditor against a quick sale of the property after a cramdown when the amount of the secured claim is determined at a time when the value of the property is temporarily depressed. By making the election, a creditor blocks the cramdown and guards against such an opportunistic sale because it retains a lien on the collateral equal to the full amount of its claim. In re Weinstein, 227 B.R. 284, 295 n. 12 (9th Cir. BAP 1998).
Treatment of an Electing Creditor
After a creditor has made the 1111(b) election, it must receive: (1) deferred payments equal to at least the full amount of its allowed claim; and (2) with a present value equal to at least the value of the subject property. § 1129(b)(2)(A)(i)(II); In re Brice Road Developments, LLC, 392 B.R. 274, 284-85 (6th Cir. BAP 2008). To more fully illustrate these requirements here’s an example:
| Present Property Value
| Total Claim Amount
| Fair and Equitable Discount Rate of Interest
| Fair and Equitable Loan Term
|| 30 Years
Based on the example, an electing creditor would be entitled to deferred payments that: (1) equal the total amount of its allowed claim of $160,000; and (2) when discounted, based on a fair market rate of interest (5%), equal at least the present value of the property ($100,000).
A total secured claim of $160,000 paid over 30 years at 0.00% interest results in 360 payments of approximately $444.45 and satisfies the first prong as the sum of the payments total the creditor’s secured claim of $160,000. However, this claim treatment fails to satisfy the second prong as the deferred payments have a present value of only $82,791.00 (based on a 30-year term and a discount rate of 5%), which is less than the present value of the property ($100,000).
Accordingly, the loan could be re-structured to provide the creditor with a nominal amount of interest on its secured claim such as an allowed claim of $160,000 amortized over 30 years at 1.30% interest per annum. This treatment results in 360 payments of $536.97 for a total payout of approximately $193,309.20 and satisfies the 1111(b) election because the sum of the payments totals at least the amount of the creditor’s $160,000 allowed claim and have a present value of $100,027.64 (approximately the value of the property). Put another way, a loan with a principal amount of $100,027.64 amortized over 30 years at 5% interest results in a monthly payment of $536.97, which provides this creditor with the present value of its collateral ($100,000). In light of the creditor’s 1111(b) election, the loan must be re-structured to provide it with a lien equal to the $160,000 secured claim amount while also providing for payments, when discounted, which provide the creditor with the present value of its collateral ($100,000). As explained, these requirements are met by re-structuring the loan with a face amount of $160,000 amortized over 30 years at 1.30% per annum.
Risks Associated with an 1111(b) Election
Notwithstanding the benefits of an 1111(b) election as discussed above, a creditor must consider the risks associated with the election. For instance, once an election is made, it is common for a debtor to surrender the collateral if the property fails to generate sufficient cash flow. If a creditor makes an election and the debtor surrenders the property, a creditor may realize less than its loan balance at a subsequent foreclosure sale. Additionally, a debtor may seek to satisfy a creditor’s 1111(b) election by proposing an extended loan term beyond 30 years or a balloon payment due at maturity. Accordingly, prior to making an election, a creditor should consider whether it would be amenable to those terms or, alternatively, whether it is willing to incur the litigation costs of disputing such terms. Finally, once an election is made, the creditor no longer has an unsecured claim. Consequently, it loses its right to vote on the debtor’s Chapter 11 plan on account of its unsecured claim as well as any defenses to confirmation available to an unsecured creditor, such as the absolute priority rule.
As the real estate market continues to recover, creditors should consider the benefits of the 1111(b) election when defending against Chapter 11 cramdowns. It can be an effective tool to limit principal reduction and even prevent confirmation of a plan. Additionally, the 1111(b) election may provide a creditor with significant leverage in negotiating the treatment of a claim in a plan. In many instances, once a creditor has timely made an election, a debtor may submit an amended proposal providing for a greater valuation or interest rate in an effort to persuade a creditor to withdraw its election. Accordingly, undersecured creditors should consult with their local bankruptcy attorney to determine whether an 1111(b) election is advisable in a specific case.
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